13 September 2007

Getting Paid To Clean Up Your Own Mess:Private equity firms profit from their own overreaching.By Daniel Gross

Back in July, we suggested, tongue firmly in cheek, that the Blackstone Group, the private equity firm that had just gone public, could take advantage of its plummeting stock price by taking itself private. A Blackstone leveraged buyout of Blackstone would have provided a hypothetical example of a Wall Street firm profiting from the ill effects of its own overreaching—while investors and the reputations of those who sold its securities would suffer.

Sometimes, life imitates fiction. When the Global Equity Opportunities fund, a hedge fund managed by Goldman Sachs, blew up in August, investors who had entrusted their funds to the Wall Street titan suffered big losses. Goldman bailed out the fund by rounding up $1 billion from rich investors and $2 billion from its own coffers. When markets are volatile—as they were in August—successful investing is all about the entry point. If a stock finishes the month at $20, those who managed to buy at $10 have doubled their money, while those who bought at $40 are out 50 percent. When it comes to its own hedge fund, Goldman clearly bought at $10. As the Financial Times reported, "Goldman Sachs made $300 million last month from the rescue of one of the investment bank's troubled hedge funds, even as external investors lost more than a fifth of their money." As one investor in the fund told the FT: "It is typical of Goldman to find a way to profit from this disaster."

Private equity firms are now playing a variation on this theme. As the buyout boom crested this year, private equity firms struck ever-bigger deals for ever-larger companies at ever-richer prices: Kohlberg Kravis Roberts agreed to pay $24 billion for First Data and $32 billion for the utility TXU. In June, a consortium struck a $48.5 billion deal to acquire Canadian telecommunications company BCE. During the boom, private equity firms were able to demand lenient lending terms from fee-seeking banks. Typically, banks like Citigroup would commit to fund loans and then sell them off later to investors. But today, investors aren't particularly interested in such loans. The result: Banks are sitting on a few hundred billion dollars of debt committed to buyouts. And as credit conditions worsen, those loans lose their value. In other words, the overreaching of private equity firms like KKR, the Blackstone Group, and the Carlyle Group has reduced the value of bank loans. The Wall Street Journal reported today that Citigroup sold $1 billion in loans for Allison Transmission, the subsidiary of General Motors that is being bought by the Carlyle Group and Onex, to "a group of hedge funds, loan funds and commercial banks at 96 cents on the dollar"—thus taking a $40 million loss. And there's plenty more where that came from. Analysts say banks are sitting on up to $400 billion of bank debt and bonds needed to finance mega-deals.

And guess who wants to buy them? Private equity firms. Last month, Henny Sender of the Wall Street Journal reported that the Blackstone Group, Texas Pacific Group, and the Carlyle Group are interested in snapping up discounted bank loans. "Executives at many private-equity firms say that could even include investing in the debt of their own deals," Sender wrote. Last week, the Financial Times reported that "Goldman Sachs, Lehman Brothers, Apollo, Texas Pacific, Blackstone, GLG Partners, Oaktree Capital and Blue Mountain" are beating the bushes to raise funds aimed at purchasing discounted bank loans.

It sounds very complicated and convoluted. Private equity firms are raising money from investors, which they will use to buy the loans made by banks to private equity firms, who are using money raised from earlier investors to buy companies. One interpretation of this dynamic: Wall Street is an efficient self-correcting machine. There is a vast supply of bank debt for sale, and the private equity firms are providing a chunk of the demand.

The best metaphor I can think of is this: You pay your friend a few dollars so that you can host a small party while she's out of town. You leave the pool filled with garbage, beer cans, and human waste. The next day you show up dressed as a pool cleaner and charge your friend a few bucks to mop up the mess you made.